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Coming Week: Upside Down

Recession is no longer the taboo word on Wall Street. It's being tossed around like confetti.

The new phrase that can't be uttered is "systemic risk," and with bond insurer Ambac (ABK) losing its triple-A credit rating from Fitch Ratings on Friday, the real risk of a financial disaster will be widely whispered into the next week amid the possibility of more downgrades for the industry.

T.J. Marta, fixed income strategist with RBC Capital Markets, estimates that roughly $2.5 trillion in outstanding debt is backed by bond insurers like Ambac and MBIA (MBI - Get Report), and credit downgrades are a mortal threat to their business models.

If the bond insurers fail, that raises the specter of a massive wave of wealth destruction in a global financial system that is flooded with illiquid and opaque derivative securities of which there is little understanding, except that their value is connected to credit ratings on structured finance securities.

"This is going to be worse than anybody thinks," says Marta. "What I heard from Ambac [on Friday] is that they're throwing back the lifeline and saying, 'We're not going to make it.' On a fixed income trading floor, that means the world truly is upside down."

On Friday, Ambac said it was abandoning its plans to raise $1 billion, a day after Moody's Investor's Service threatened a credit downgrade. Fitch responded by cutting the premium triple-A rating to double-A for Ambac Assurance Corp., Ambac Assurance UK Ltd. and Connie Lee Insurance Co. and slashing holding company Ambac Financial Group from double-A to single-A. Fitch also warned that more downgrades could be in store.

In the end, the Dow Jones Industrial Average declined by 4% for the week. The Nasdaq logged a decline of 4.1%, and the S&P 500 was the worst performer, ending down a whopping 5.4% over the five sessions.

Dr. A. Gary Shilling has been a respected Wall Street maven since 1963. His record shows that he's not a perennial negativist, but for several years, he has predicted the housing downturn and credit crisis that has come to pass despite the many denials from high places.

Even with his vindication, Shilling's outlook is still gloomy.

"Next week, we'll be waiting for not just the next shoe but many more shoes to drop," he says. "That's the bottom line here. The subprime slime was the first to go because those are loans to the least credit-worthy borrowers -- the most vulnerable. But you had plenty of speculation in commercial real estate, emerging market debt and equities, commodities, leveraged loans, junk bonds and a whole host of areas that are extremely vulnerable."

Shilling says systemic risk is a legitimate concern because of what he calls "counter-party risk" to investors on the other end of a derivative trade from the loans going bad.

"If you get widespread counter-party failures, then the whole system is in trouble," he says.

Next week has little in store in terms of scheduled economic news, but the possibility of an intra-meeting rate cut from the Federal Reserve is a real possibility. Marta notes that the market is pricing in a 72% chance that the Fed funds rate target gets cut by 75 basis points by its next two-day meeting beginning Jan. 29. If the central bank doesn't step in before then, that would mark the first time the Fed has moved rates by more than 50 basis points since 1982.

Meanwhile, Wall Street will be looking to Washington, D.C. for an economic stimulus package to help consumer spending that congressional Democrats and President Bush are vowing the cobble together quickly with the blessing of Fed chief Ben Bernanke. Bush signaled he won't demand that his earlier tax cuts be made permanent as part of the package, raising the possibility of a quick compromise on legislation, even though Republicans and Democrats are sure to disagree on how to go about it.
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